Because interest rates have risen in recent months, financial commentators are getting carried away with a “new paradigm” narrative suggesting that interest rates will be higher indefinitely. They cite trade policy, “green” investment, AI, war, deficit spending, and “friend-shoring” to suggest the U.S. (if not the world) is in a new post-pandemic inflationary era, the Fed’s neutral rate is higher, and interest rates can’t fall very far even when the Fed cuts interest rates. I addressed many of these things in my 1970’s piece, “It Won’t Be a Repeat of the 1970’s” from December. The great David Rosenberg of Rosenberg Research also wrote about this topic on Tuesday. In his morning piece, he said,

“We continue to push back on the prevailing narrative that we are in some sort of brand-new era. The AI boom is an inflection point in the technology curve, to be sure, but so was the Internet and since its introduction and adaptation in the late 1990s, we still ended up having three recessions since that time. The business cycle never died even though, back then, like now, that was the widespread market perception.

Yes, government spending and chronic deficits are part of the landscape, but so were they in the Reagan era of the 1980s, and inflation went on a secular downtrend nonetheless. Globalization has seen its complexion shift but has not really gone into reverse. Climate change is obviously a critical new theme, but the implications are a double-edged sword in terms of a higher cost structure but also depressed economic growth impacts. Global conflicts are a problem, but over the centuries, these have been the norm as opposed to the exception. Again, the Korean War in the 1950s did not exactly usher in a multi-year inflation process. Not everything leads to higher inflation!  What lies ahead that will prove disinflationary is the mean-reversion in the personal savings rate from its depleted 3% level back to the pre-COVID-19 norm of 8%. The spending associated with excess savings from the prior massive stimulus checks is in the rear-view mirror. Broad measures of unemployment are already back to pre-pandemic levels and worker confidence has rolled off the cycle peak — and whatever happened to that “Great Retirement” theme that dominated the headlines back in 2021 and 2022? There is a good chance that, actually, the “new normal” will be a rollback to the “old normal,” including the secular forces of aging demographics, extreme income and wealth inequalities, and massive debt burdens — all of which are constraints on both aggregate demand and real interest rates.”

The Treasury market grappled with a similar endless barrage of reasons for the bond sell-off last October only for Treasury yields to fall 100+ basis points in the ensuing three months just because economic data weakened. None of the slow-moving reasons suggested at the time changed in those three months but yields fell because the outlook for inflation and real growth fell. The same thing is happening now. Rates have risen and interest rate cuts have been pushed further away because economic data has improved since December. Economic data has been weaker since mid-April, but it will take a little more for it to be considered a trend.

I am creating a novel daily composite economic index to demonstrate how economic data is influencing the Treasury market and the Federal Reserve. Existing composite indices are either too slow (released monthly in arrears, like the Chicago Fed National Activity Index,) focus on real growth (CFNAI and Dallas Fed Weekly Economic Index) or, measure the difference between economic releases and economists’ surveys (surprise indices.) This index measures how U.S. economic data is growing or shrinking, is updated daily when economic data is released, and includes real and inflation economic data. I will introduce it more formally soon and it may change before it is released; this is a sneak peek.

This index helps to tell the story of how interest rates have moved over the last year (see chart below.) The 2-year yield has broadly tracked the index, but economic data leads it. In other words, economic data will begin to turn, but it is only after the trend is sustained that the 2-year yield begins to turn. Logically, it takes a little while for the Treasury market to become convinced of a turn surrounding broad inflection points in the data.

Upcoming economic data released tomorrow and next week (consumer spending, PCE deflator, ISM surveys, and the Labor Market) will determine if the slowdown we’ve begun to see since mid-April is a trend. If so, the Fed’s hawkishness, “the higher for longer” theme, and “new paradigm” talk will abate—interest rates will fall. There is nothing to suggest that the business cycle has been skipped or that it will work different this time. The severity of the recession will determine how far rates fall, not where today’s estimate of the neutral rate is.